$4.1 Billion in Investor Funds Have Been Frozen Overnight

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Before we get to how much worse the global financial crisis of 2008 could get, what about the local market? The great cash freeze of 2008 is upon us. Today’s Australian papers tell how fund managers AXA, Perpetual, and Australian Unity have frozen redemptions from their mortgage funds. Uh oh.

At least $4.1 billion in investor funds have been frozen overnight. It’s an effort to halt the migration of investors from non-guaranteed mortgage funds toward government guaranteed bank accounts. Notice that those seeking redemptions are not referred to as “depositors” but as “investors.”

That’s a crucial distinction. The funds management industry in Australia (and around the world, to be fair) has thrived by promising investors income, capital gains and safety. Normally you’d expect to get only one or two of those benefits from a single investment. But getting all three?

Hmm. You can find a holy trinity in theology-where one entity can exist in three different forms (Father, Son, Holy Ghost). But in the investment world, we’ve yet to see any single kind of messiah investment than be all things at all times to all investors.

But enough of theology. What you’re seeing now is a financial effect with a political cause. Investors are behaving in a perfectly rational manner by shifting their assets from uninsured vehicles to insured bank accounts. If the government wants to change the behaviour (other than the simple coercion of freezing redemptions, the rational action taken by the fund managers) then it needs to change the incentives.

That is, the fund managers either need to guarantee their products or secure some kind of emergency funding from the government or the Reserve Bank to ensure account holders they’ll be able to get their money back. Meanwhile, the unintended consequences will continue to unfold. If the mortgage funds provide funding for commercial and residential property development, won’t those funds now be much harder to get? That won’t be good for property…

Over in the share markets, the ASX opened with cautious optimism, following New York’s overnight lead again. But it has since turned down. About the only interesting observation we can make is that BHP is providing the most encouraging and discouraging news of the day.

The discouraging news is that its share price looks set to fall below $24. Investors are worried that crashing steel prices will slow demand for iron ore and coking coal-the two big pillars of Aussie (and BHP) export earnings (although don’t forget BHP is Australia’s largest oil producer too). As BHP goes, so goes the All Ords. Down.

The good news? Don Argus is doing exactly what Diggers and Drillers editor Al Robinson said he would. He’s making a shopping list of cash-strapped juniors that are looking for a savoir. Argus told investors, “We believe our balance sheet places us in a unique position in the resources sector to take full advantage of not only the recovery when it occurs, but also in capitalising on opportunities that will no doubt arise in this cash-strapped external environment.”

The big fish have an empty belly and a full wallet. They’ll be dining on the juniors soon.

A quick note on gold at the Perth Mint. There is gold at the Mint, of course. It’s just that most of it is not for sale. It’s in allocated and unallocated accounts which belong to the Mint’s customers. The Minters can’t just take someone else’s gold and turn it into new bars or coins. Because, you know, it’s someone else’s gold. As far as we know, the only gold coins currently for sale are the 1oz coins.

Finally, let’s take a step back from the day to day trading action and remember what’s going on. The bankruptcy of Lehman Brothers has kick started a giant global de-leveraging. It’s driving the yen and the dollar up, while commodities, shares, and nearly everything else goes down.

“The dollar and the yen are rising in a massive, global short squeeze as investors and speculators are forced to delever,” writes Randall Forsyth in Barrons. “Borrowings effectively are short sales of a currency. Repayment means covering those shorts, or buying back those currencies. Both the dollar and the yen have been used to fund investments, so they’re the objects of buying-not as vote of confidence in the U.S. or Japan, but forced short-covering.”

All those borrowed dollars and yen found their way into shares and commodities. But who borrowed them? Hedge funds mostly (hedge funds run by banks, insurance companies, and private individuals). And how do you repay borrowed money? You have to sell your assets.

It’s tempting to call the massed selling of stocks irrational. But this is based on some investors looking at stock valuations and finding them cheap on an earnings basis, or looking at the cash on the balance sheet. But what you have here are extremely motivated sellers. They HAVE to sell. It’s all quite rational.

Normally, when the seller has to sell, it’s a very good time to be a buyer, hence Buffett’s chest-thumping op-ed piece. But you don’t want to be a buyer if there’s more forced selling in the pipeline. And that is now the key question in the market.

How much leverage is left to be unwound?

Well, before the crisis hit, hedge funds controlled US$2.4 trillion in investor funds. They would have used that to borrow trillions more (with leverage ratios of 10-1, 20-1, and 100-1). This explains how much “value” was added to global stock and commodity markets since 2003-and how quickly it’s disappeared as access to credit evaporated for hedge funds and they faced margin calls AND bans on short selling.

The result? All those assets purchased by hedge funds with borrowed money are being liquidated. And the funds that were not hedged at all (long-only, with massive leverage) are not long for this earth. Who are they going to take with them?

“In a fairly Darwinian manner, many hedge funds will simply disappear,” Emmanuel Roman, co-chief executive officer of GLG Partners Inc., told investors at a hedge fund conference in London. “This will go down in the history books as one of the greatest fiascos of banking in 100 years.”

True that.

Governments want to regulate hedge funds. They’ve already begun to do so by preventing them from shorting. But remember, if a hedge fund can’t short, it can’t really hedge. Performance suffers. Investor redemptions increase.

The more hedge fund investors want their money back, the more selling in the markets. The very regulation designed to prevent falling stock prices via short selling may accelerate falling stock prices via hedge fund redemptions.

In fact, only the lock-ups by hedge funds which prevent investors from getting their money back are preventing an even greater pace of redemptions. But when those lock-ups expire, watch out. That’s assuming the funds are still operating and haven’t suffered irreversible losses.

Either way, you see how a new low on the markets is entirely possible. Our prediction? Stock markets are going to get a hefty global bounce in November. There are at least three events on the horizon that could provide the boost.

First, if Obama is elected, you have the end of uncertainty about the U.S. election (and some highly irrational optimism that things will now be different, better, and nicer). Second, you’ll get a new stimulus plan from the Democratic Congress in the U.S., which should give stocks a bit of a kick. And third, the big G20 meeting in Washington Kevin Rudd is headed too. Something that looks and feels good should come from that.

Those three factors may conspire to produce a convincing looking bear-market rally into Christmas. That would be the sucker’s rally of 1929-1930. Or, we could be dead wrong and deleveraging may simply overwhelm everything else. It’s also possible, of course, that the bulk of the hedge fund deleveraging has already taken place. But we’re not counting on it.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Where will all the cash, now being redeemed from asset sales go? Some of it will go back into the market as Dan suggests. Some will then be furnaced in predicted suckers rallies.

    The demand for US dollars caused by deleveraging will cease only when the deleveraging essentially ends (and the USD tumbles). Would I be correct in surmising that becauue financial instruments can have a long shelf life this process will take some years? Reinvestment can only happen after assets find their floor but this has been deferred by central banks action.

    In Australia, the property bubble will have to burst before reinvestment in this sector can happen but commercial leases can also have shelf lives of a number of years. And residential bubbles are still floating because the supply (of property) has been artificially limited and contorted into unaffordable options for decades.

    I don’t know where I am heading with this at the moment. My dodgy crystal ball needs a recharge. Amongst other things I need to work though the logic behind Steve Keen’s conclusion that Capital Assets Pricing Model (CAPM) is nonsense.

    Coffee Addict
    October 24, 2008
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  2. I’m trying to work my way through this too.

    The US asset disposals started the ball rolling, and were either in-country being bought by the US govt, or foreign SWF’s buying US assets with USD generated by dollar denominated export sales. So too with creditor countries buying UST’s? mmmmmmmmmm

    Is there dollar demand from elsewhere to buy USD’s outside waning USD merchandise and commodity trading? There is likely more Mt Gibson’s out there sitting on USD futures for contracts that might not come in.

    There is offshore capital flight from selling third country currencies. Like Japanese housewives exiting AU stocks and AUD and foreign bank branch lending in AUD but surely this is going back to Yen (the Yen exchange rate reflects it but they aren’t buying USD).

    Commodities securities investors from the old world are likely pulling back. And for this reason the pound may be temporarily afloat.

    But maybe the US hedge funds and the US foreign bank branches are the real USD buyer/redeemers. Once they are out it tanks ….

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  3. To a previous comment most of the cash doesn’t go anywhere. Just because the market capitalisation of the market is a certain value doesn’t mean that’s what the market has in money. When deleveraging happens and loans are repaid the money is effectively destroyed. So it never goes anywhere.

    In fact the current price is only achievable because there is a buyer – that’s it. It’s not a money pot. You put money in and lost it in the hope that someone will put more money in later to get it what you bought. The money is never really in the market, only during the buy/sell transaction is the money in the market at all.

    Good to understand if you are trading. Deleveraging is a deflationary effect precisely because now there is less money in the economy. Therefore money itself becomes more valuable than everything else.

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  4. Hedge fund hedge funds just where are they who are they?What private investor knows or invests with them where can they be found where are their performance records?,Hedge funds is all we hear yet their visability is invisible.

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  5. Let’s not forget there are funds and people sitting on piles of cash waiting to jump back into the market at some stage. Of course I have no idea at what level the bargain hunters will pounce, and to be honest I thought they would have already been active by now. (I was actually trying to be a bargain hunter when the ASX 200 was around 4800…oops!)

    There are also many companies still strong enough to be in acquisition mode (such as BHP, ANZ, CBA) and I am sure those companies are looking as we type, at possible takeover targets.

    So at same stage asset values should stabilize and things get back to normal. The question is when, and let’s not forget it took a decade for Japan to sort out it’s post bubble mess, so I am just hoping the U.S. can sort out their mess quicker.

    Personally I think the way the U.S. will get out of this mess is by selling more and more of good old U.S.A to foreign buyers. (we have already seen this start to happen) Perhaps we are really witnessing the shift of economic power to Asia rather than just predicting it will happen?

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  6. Bank guarantees hurt ALL asset classes including gold. In the short term you would be mad to invest in anything other than a guaranteed bank deposit.

    Fiat currency doesn’t actually get furnaced by investment losses. It simply exchanges hands and reduces its velocity when consumption slows. When the same volume of currency exchanges hands less frequently we get poorer due to the underlying reduction in economic activity. Transferring money from businesses and investments to term deposits ALSO REDUCES VELOCITY. By fully guaranteeing bank deposits Governments are throwing petrol into the financial inferno.

    I would have thought that a guarantee on the first $50K combined with the availability of commercially priced insurance for the rest would have done the trick. But now we have yet another fundamental misallocation of resources.

    As Greg said there is plenty of money waiting to be reinvested. Some will be reinvested but a lot won’t be. A lot of the waiting cash will wait to long and be inflated away.

    Coffee Addict
    October 27, 2008
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  7. Coffee Addict what you say makes a lot of sense. I think the government made a major blunder by guaranteeing deposits. It does not make any sense to tell people our banking system is sound and then undermine confidence by guaranteeing deposits. The way deposits are guaranteed in banks is via regulation and good bank risk management.

    The notion that if Australia did not guarantee bank deposits then money would go elsewhere has of course been proven incorrect by the continued exodus of funds and the falling $AUD. In my view this blunder has been just as bad as the ban on short selling which as we all know has done nothing to stabilize the market.

    If the Australian government wants to show they have confidence in Australian banks and companies, then why don’t they just get the future fund to use some of that cash and buy stocks? Perhaps instead of investing 10 billion in a pump priming exercise they could look at taking some stakes in BHP etc? How about even setting up an Australian sovereign wealth fund?

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  8. Not much point guaranteeing deposits. My wife overhead a story about a gentlemen who recently tried to withdraw $100,000 from his $500,000 account. The bank refused, claiming they could only give him $10,000 and a further $10,000 the following business day. He spoke to the manager, took the $10,000 and said he would come and get the rest the following day.

    When he arrived the next day they refused to give him any more than another $10,000. He asked to close the account. The bank said we can’t do that”. He had to remind them it was his money not theirs (apparently). After a ruckus with the bank manager they finally relented and game him the $90,000 as long as he remained a customer.

    I don’t know the bank involved, but I’d be interested if other people are having dramas withdrawing money.

    Reply

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